ECS Holdings and Multi-chem shows the downside of distribution business

Distributors usually are low margin business. I always thought that Neratel and ECS Holdings is like one of them. Recently, I discovered another one called Multi-chem.

While folks looking for dividends may like ECS when they were yielding 7.5% and Multi Chem when they are currently yielding 8%, how safe is your dividends?

Multi-chem

You might not know Multi-chem but IT industry folks will know their subsidiary MTECH, which is a rather wide distributor of security and networking products such as Checkpoint, Riverbed and Splunk among other things.

The dividend yield on Multi-Chem looks good. Based on the 1.1 cent dividend and at a price of 13.4 cents, that comes up to 8% yield.

The company is Net Cash as well.

With a profile like this it makes a potential good dividend play. It gets better when you realize that their IT business grew even in the midst of the 2008 and 2009 dark periods.

Addressing debts and non-performing segments

What was dragging them down in those times to losses was their legacy PCB manufacturing business.

To be fair, the management have always been shown to be rather good listeners to what needs to be done. The issue then in the financial crisis was debts and a failing manufacturing business.

So a talk with the Investor relations have shown that steps were taken to stem these two areas.

Multi-Chem today looks much better with the IT product sales generating 90% of the revenue.

The thing that attracts me to Multi-Chem was that the products that they distribute comes with necessary maintenance and licensing, which are recurring revenue generators.

These security and network products requires certain set of expertise to operate, and thus Multi-Chem also provides training services.

It is to be believed that they have different relationship with the products that they carry.

In the case of Checkpoint, they could distribute the products and provide the after sales maintenance and training services.

To cushion the impact of a single country slowdown, they have expanded to a wide geographical reach.

1st Qtr slowdown

With all this in mind, especially in view of their strong 2008 and 2009 performance, I would have thought that we have a silent winner here.

However, recent quarter results have shown them to be suffering a loss.

The main issue

Slow down in overall sales regionally but Singapore was particularly slow

1st quarter usually is a slower quarter

Administrative and Selling expenses which cannot scale down accordingly

A talk with the investor relations reveal that majority of the costs in selling expenses and administrative is attributed to training the workforce to have a level of competence. You cannot scale that accordingly based on demand. Some things need to be invested.

No doubt this is just one quarter, and I may be overreacting. But the conversations with the IR doesn’t give a confidence that management see this as a non-issue.

To them, it seems you have to be ready that there are years that there can be losses.

Not so consistent free cash flow and dividends?

This will mean a not so consistent free cash flow and thus perhaps a not so consistent dividends.

A check on SGX shows that in recent times, Multi-Chem have failed to pay (note: not scale down) dividends in 2007, 2009, 2010.

That is 3 big years.

If by selling off their non-performing segment we should expect a leaner, better dividend company, then this first quarter results may domino to a full year of bad results.

Would Multi-Chem pay then?

During the dialogue with the IR, much have been made about Multi-chem not having a formal dividend policy and that they have paid good dividend during good years.

There are every indication that I could eat my words when the next 3 quarters turn out to be great.

But 1st quarter shows that economic factors does affect the business of these low distribution businesses.

Changing product mix demand

ECS in contrast, is suffering these 2 years with falling profitability.

The main reason is that there is a shift in consumer demand from desktops and laptops to more mobile devices.

This shift also changed the way ECS distributes their products and thus their margins shift accordingly.

A look at the segmental reporting of ECS will show that for low margin businesses, what a shift in margins can do for your business.

In this case a negative way.

Distribution which contribute a large portion to profits, impacted the cash flow, and dividends respectively.

Is product distributor bad dividend distributors?

The way I look at it yes and no. While I thought distributing security products and having maintenance and training makes Multi-Chem better, in this case it actually made their short term profits look bad.

The need to invest in building up competent man power for Multi-Chem and ECS so that they “value add” to their customers adds that layer of overhead during times of poor sales.

Pure competent stockists may be better dividend distributors

If you remove that value add, it may make them look like a commodity business and that sounds like a vulgar phrase in itself.

But it may be better in that they can scale up and down their costs depending on the demand of their business.

The steel stockist like Lee Metal, Sin Ghee Huat, Asia Enterprise Holdings have shown that they can go 20 years profitable. That is in the face of numerous recessions, booms, turmoil.

Closer to ECS and Multi-Chem, you have 2 hong kong based electrical component distributors in Karin and Willas Array.

Karin and Willas Array have 1-2% profit margin, but they were able to navigate the 2008 and 2009 crisis rather competently.

In the case of Karin, their dividend track record is rather good.

Management Culture as the important factor

As with REITs and Trusts, to be able to be continuously profitable for 30 years is no easy feat.

Reading the reports of Willas Array and Karin in 2008 and 2009 will tell you the value of good management.

Being able to scale up and down at the right time, change the product mixed while not impacting cash flow for long periods is something that we come to value as dividend investors.

About Investment Moats

Kyith Ng is an investing and technology blogger and the founder of InvestmentMoats.

Investment Moats shows you how differently you can Build Wealth to reach Financial Independence/Retirement. If you are interested in Dividend Income Investing, Value Investing and Saving Money, tune in regularly to our blog.